Why Oil prices could languish in 2015 (Updated)

I’ve recently posted about oil – here – where I explored the different pressures on oil price beyond pure supply and demand. As a follow up it remains insightful to consider that oil supply and demand could play only a small role in oil pricing through 2015… But that’s what one Oil commentator recently suggests.

Before explaining more , why am I focusing on oil?

Because oil pricing has a major impact on business costs both in generating production, but also in transportation, travel, local energy costs and consumer confidence… Lower oil is generally good for business ( unless you are in the energy business), and it also has an impact on regional currencies as well.

Dan Dicker, writing in Oilprice.com shows how the financial aspects of oil overwhelm supply and demand fundamentals, delivering counter-intuitive pricing in the short to medium term. Looking at these financial flows shows why the oil pricing is destined to stay low for an extended period of time, even perhaps after the glut begins to clear and US oil production starts to drop.

None of these reasons have to do with supply or demand and are entirely financial – but help to describe why oil will continue to be weak for the next six months.

1 – Oil Company bankruptcy worries: Oil companies which are trying to avoid default risk are more likely to hedge oil futures at $65 than they are at $75 – even though these hedges are below break even prices for many of them. The companies seek to mitigate the immediate risk of bankruptcy, should oil go down to $50 a barrel, but this hedging keeps pricing oil low.

2 – No more Investment Bank marketing: Most US investment banks have given up on their trading desks in oil and other hard commodities so there is much less buying pressure (for investment) when pricing is low.

3 – Passive commodity index funds are selling: The recent incredible commodity deflation (which includes oil, base metals and grains) has encouraged those who have invested in commodity indexes and ETFs to sell, and there’s no one buying. The redemptions on passive indexes are at a level not seen since 2008 providing pressure on oil selling and no impetus to oil when pricing is low.

4 – No good case to stock up on oil: Where, before, you could make a case that commodity inflation had to accompany growth in the US, you can’t make it now. Further, while geopolitical unrest in the Middle East and Russia were terrific incentives to bet on supply shortages in the last 10 years, the markets are suddenly entirely unimpressed with them today. So no pressure to buy oil now, when its low.

5 – The US Dollar remains strong: With most Asian nations (and maybe the EU) chasing devaluation to stimulate their economies, the US dollar will continue to show strength, adding downward pressure to oil prices.

When you combine these five factors you have few reasons to expect an oil rally in the near future.

What could you look for as a warning of impending oil price rises?

a drop in US production in shale oil for the 1st quarter of 2015,

mergers or outright bankruptcies of smaller US Oil exploration and production companies,

perhaps an indication that EU Central bank easing is adding support to EU markets boosting demand.

It wouldn’t hurt to see US gasoline demand increase from lower prices as well – an acceleration in US truck sales would be a good initial sign of that.

On Friday, (12-12) the International Energy Agency cut its forecast (again!) for global demand growth in 2015, this time by 230,000 barrels a day, to 910,000 bbl/d.

That feeble demand growth continues to meet booming supply – largely from drillers in the US, which borrowed a large amount of money to drill their wells. Now they need the cash flow from these wells to service their debts just to survive. They can’t afford to cut production, no matter how low the price. Some of their production is hedged. But even the rest: the lower the price, the more they have to sell just to meet to their cash flow requirements. This brings an even greater impetus to lowering pricing.

Production isn’t what they’re going to cut. Instead, they’re slashing new projects and future capital expenditures. This way, they can survive the low prices repaying bonds and loans. And those cuts won’t impact production for months, which means we’ll face a period with a serious lack of US supply, driving pricing higher.